In this Enforcement Order, the SEC described a “revenue management scheme” orchestrated by the respondent, Marvell Technology Group, and the imposition on Marvell of a $5.5 million penalty and cease-and-desist order—not because of the scheme itself, but rather because the company failed to publicly disclose the scheme in its MD&A or to discuss its likely impact on future performance. The Order demonstrates that, even if a scheme involving unusual sales practices may not amount to chargeable accounting fraud, failure to disclose its distortive effects can be misleading and result in violations of the Securities Act and Exchange Act.
According to the Order, Marvell, a producer of semiconductor components, had experienced a significant decline in sales and had missed recent targets in the guidance that it had provided to analysts. Historically, in setting revenue and sales targets, the company had followed a bottom-up approach, with sales teams contributing forecasts, based on their understanding of customer needs, to help set the targets. But management was concerned, in light of sales declines, that the sales group needed to be more aggressive and, to that end, instituted a top-down process to establish sales targets, notwithstanding protests from the sales force that the targets set were unrealistic.
Faced with a persistent decline in customer demand and concerned about continuing to miss guidance (and its potential adverse effect on the stock price), the company developed a “pull-in plan” to accelerate, or “pull-in,” sales that had originally been scheduled for future quarters to “close the gap between actual and forecasted revenue, meet publicly-issued guidance, and mask declining sales.” The SEC noted that the company’s actions were largely within the perimeter of its revenue recognition policy, which, although not publicly disclosed, contained a section related to pull-ins. The policy “defined a pull-in as ‘a transaction where Marvell initiates and obtains agreement from customer to modify an existing sales order scheduled shipment date from a subsequent quarter into the current quarter.’ The policy required formal tracking of pull-in transactions.” According to the SEC, the pull-in plan “was orchestrated and directed at the highest levels of Marvell. Senior management, including executives in sales, finance, and sales operations, were aware of the pull-in effort and tracked the company’s progress in meeting its revenue targets through the use of pull-ins. Senior management also routinely pressured sales managers to obtain additional revenue through pull-ins to meet their targets.”
To persuade customers to agree to the acceleration of sales, the company offered various financial incentives, such as “price rebates, discounted prices, free products, and extended payment terms, at times inconsistent with its revenue recognition policy. Yet, even with these incentives, Marvell’s customers were at times reluctant to agree to pull-in sales.” Pull-ins were used during three quarters, even as sales managers warned that the pull-ins were overstating actual demand. As the quarters progressed, the pull-in plan continued, yet the gap between forecast and actual revenue became more acute as market conditions declined and, significantly, the pull-ins cannibalized future sales.
Senior sales and other employees cautioned senior management about the adverse impact of the pull-in plan, but management “ultimately ignored the warnings and pressed ahead with the pull-in effort.” In one meeting, an employee involved in financial reporting even cautioned senior management that the
“use of pull-ins could trigger disclosure obligations because they could be masking a downturn in the company’s financial results. The employee cited prior SEC actions against public companies that had distorted their financial results through unusual sales practices. Rather than heed the employee’s warnings, Marvell’s senior management did the opposite—the warnings were ignored, and they misled the employee by falsely asserting that the pull-ins were not being used primarily or solely to meet revenue guidance. At the conclusion of one of the aforementioned discussions, the employee was directed to send an e-mail to senior management indicating that there were no issues with the pull-ins. The employee sent the e-mail as requested.”
Throughout, the company filed periodic reports that failed to disclose in MD&A the pull-in strategy or that a “significant portion of its revenue had resulted from the use of pull-ins intended to meet the company’s public revenue guidance.” As a result, the Order observed, the disclosure misled investors by creating the impression that guidance targets were achieved “organically,” as opposed to through the use of pull-ins, masking the declines in revenue performance and declining market conditions. In addition, the Order charged, the company failed to advise investors of a material trend—that, as pull-ins cannibalized future sales, implementation of the pull-in strategy was reasonably likely to materially and adversely affect future performance. Under Item 303 of Reg S-K, companies are required to describe in MD&A “any known trends or uncertainties that have had or that the registrant reasonably expects will have a material … unfavorable impact on net sales or revenues or income from continuing operations.” With this Order in mind, each company and its auditors will need to consider carefully whether any of the company’s conduct, such as engaging in pull-ins or other unusual practices, may be distorting results, disguising market conditions and potentially affecting future performance, requiring disclosure in MD&A.
Notably, the SEC was critical of the company’s internal disclosure processes, which “failed to ensure that it adequately considered its disclosure obligations surrounding its use of pull-ins.” Although the company had established a Disclosure Committee, the Committee was unable to fulfill its responsibility of ensuring the accuracy and completeness of the disclosures because the Committee was “not made aware of, nor did it consider, whether the company’s use of pull-ins needed to be disclosed publicly.” More specifically, senior management “failed to ensure that the Disclosure Committee adequately considered the issue. It failed to do so even after at least one employee cautioned senior management that Marvell’s use of pull-ins implicated disclosure obligations because they were masking declining financial results.”
Nor was the Board informed of the pull-in plan. What’s more, on “at least two occasions, in documents that were to be provided to the Board, references to pull-ins that had existed in earlier drafts were deleted.” In addition, the company “did not disclose to its independent auditor that the company had attempted to meet its public revenue guidance through the use of pull-ins.” As a result, none of the traditional safeguards and gatekeepers—the Board, the accountants, even the Disclosure Committee—were able to function effectively to prevent the disclosure omission.
After the Board first became aware of the use of pull-ins to meet public revenue guidance, the company announced a delay in filing its next Form 10-Q and “the commencement of an internal investigation to examine, among other things, the company’s use of pull-ins. Shortly thereafter, Marvell’s independent auditor resigned.”
The SEC concluded that the company’s “misleading statements were material. A reasonable investor, in considering whether to purchase or sell Marvell securities, would have found it important that Marvell was using pull-ins to generate sales for the purpose of meeting publicly-disclosed revenue targets and mask a significant downturn in sales, and that the pull-ins would adversely impact future revenue.”
The SEC found that the company violated Exchange Act Section 13(a), and Rules 13a-1, 13a-13 and 12b-20 thereunder, by failing to disclose the use or impact of “pull-ins to mask declining sales and markets, a trend, event, or uncertainty that was known to Marvell and was reasonably likely to have material effects on the registrant’s financial condition or results of operations.” Noting that the company had sold shares to employees under its employee stock purchase plan, the SEC also found violations of Securities Act Sections 17(a)(2) and (3), which do not require scienter and may be based on negligence.